Search

“Unusual share price movements in the two days before takeovers announced by U.K. companies last year fell 9.4 percent, in a sign that insider trading may be decreasing.

There were ‘abnormal pre-announcement price movements’ before 21.2 percent of the 118 deal notices in the U.K. in 2010, the Financial Services Authority said in its annual report, published yesterday. That was down from 30.6 percent in 2009, and the lowest rate since 2003.

Factors other than insider trading, such as speculation by analysts or the press about an upcoming deal, or information leaks, could be the cause of the share price movements, the regulator said. The FSA has made market abuse and insider trading by top bankers a focus of its enforcement efforts.”

The SEC mandate is to provide a fair trading environment; a quick look at the options market immediately prior to Buffet’s Lubrizol purchase indicated heavy open interest even before any newswires reported the takeover agreement. The option interest was uncharacteristic and stretched compared to historic performance. Purchases of open calls were amplified and the fact that this has not been investigated is disgusting. The SEC is clearly behind the curve; it has not even registered with them. The laissez faire approach of the SEC undermines confidence in the ability of regulators to enforce, even if superficially.

The Government don’t understand risk, profit and complex interplays. Even after the crisis, governments worldwide encouraged financial institutions to hold more liquid tier 1 capital, and this was something that was considered to be essential. However, they specifically encouraged government paper including sovereign debt as they implied a government guarantee and these debt instruments were also heralded by the ratings agencies. It’s not the government’s job to advise financial institutions as to how they should specifically allocate their capital. Capital allocations should be weighted towards gold, silver, cash, foreign currencies, stocks, direct investments, commodities and materials. Purchasing government bonds in countries which have significant deficit imbalances should be avoided. The constant search for yield in bonds should be avoided, as they have weakened and have lost real value. There is also significant principal risk given the current inflation trajectory.

I found it very surprising that this story received so little attention in the mainstream media. This is not an attempt to resurface this or to give Madoff another platform to spew his ideas. Madoff was not a sophisticated investor and with the assets under management even relatively mediocre performance would have ensured his billionaire status. However, one area where Madoff is sophisticated and has credibility is in creating and maintaining a Ponzi scheme for an incredibly long period of time. And to borrow a quote from Gordon Gekko, “A fisherman always sees another fisherman from afar.”

A CNBC article on the subject defined a Ponzi or pyramid scheme as “a scam in which people are persuaded to invest through promises of unusually high returns, with early investors paid their returns out of money put in by later investors”. What Madoff is principally referring to is the US bond market and the system and functions which validate its borrowing capacity. The whole issue is reminiscent of the Madoff situation itself. Everyone is looking at risk, Madoff is looking at the risk of getting caught and covering any leaks, the SEC is supposed to be looking at risks in the system with a mandate of creating a fair environment, clients are assessing risk in identifying fund managers’ to manage their financial assets, and hedge funds, fund of funds and counterparties are all looking at principal risk and counterparty exposure; and everyone missed it.

The US bond market is however more visibly transparent; including the problems. 11% of US tax revenues approx $400bn are currently being paid just to service interest payments and not to cover any principal. Current interest rates on the 10yr are around half of the average since 1980. Even if we back out the Volcker spike and look at average yields since 1990 it is approx 5.66%. The average maturity of US debt is approx 4.7 years compared to the UK where it is slightly more than 14 years and Germany where it is just over 6 years. And Bernanke was well aware of this with QE2 targeting the long-end of the curve to bring down rates instead creating a spike higher.

The rollover of US debt is going to be a major challenge for the US economy. Just a small spike in the interest rate can cause the US debt service payments to double annually quite quickly because additional fiscal deficits are adding to existing burdens. The short maturity on this debt heightens these pressures. And there does not seem to be any reverse in policy in tackling debt burdens and the current speed of reducing spending in the US is running at a very pedestrian pace.

So how does a country with $14 trillion in debt, annual fiscal deficits above $1 trillion and below par ‘GDP growth’ (read my article about ‘GDP growth’) able to increase its capacity to borrow at such historically low rates? There are definitely arguments about the dollar holding world reserve status, the liquidity of US markets, the US as a safe haven and so on but these are all based on history, they are essentially backward-looking while markets are supposed to be forward looking. And of course markets are not efficient. What Madoff is inferring is that there is a whole system and infrastructure which validates and provides the borrowing capacity for the US to continue to spend money and to consume creating an unsustainable dichotomy where on the other side the East saves, invests and produces. It is essentially the same story but with different characters.

Here we have the Federal Reserve, a very elusive organisation with a mandate to create price stability and low unemployment. Their borrowing is not constrained by the discipline of gold or other precious metals, their intervention in markets in unchecked and their disclosure requirements are very dicey. The Fed itself also buys the own debt it issues and there are credit rating agencies which validate this debt at AAA with the occasional warning of a downgrade if current spending levels remain unchecked. The Fed also provides loans to banks and financial institutions at approximately nothing so there is no counterparty downside and being a sovereign institution with its own currency mitigates risk. Banks and financial institutions are able to profit just on the spread which incentivises them further.

The US bond market right now at least on the long-end of the curve is a Ponzi scheme in that the returns it promises hold no value. The only viable alternative the Fed has now is to print enough dollars to inflate its debt to erode the purchasing power and utility of the dollar. This has never worked throughout history except with it being accompanied by a default of some magnitude. The ills of excessive debt have been recorded even since Biblical times and some nomadic tribes today have been known to settle debts by offering their daughters in marriage. The honest and plausible route would be to dramatically reduce spending. Fed dynamics though have created a great trading environment on the one side but has increased systemic risks even further and has diminished our likelihood of better responding to tail risks and black swans.

CONTACT

Featured Article

Fisher investments in their own words are a multi-billion dollar company and one of the world’s largest independent investment advisory firms. They have approximately $40 billion under management. Given the events surrounding Bernie Madoff, the investigations into SAC Capital, the trial and prosecution of Raj Rajaratnam and other hedge funds, financial firms should be pursuing […]

Follow Blog via Email

Enter your email address to follow this blog and receive notifications of new posts by email.